Debt Consolidation

You may be able to lower your cost of credit by consolidating your debt through a second mortgage or a home equity line of credit.
But these loans require you to put up your home as collateral. If you
can’t make the payments — or if your payments are late — you could lose
your home.

What’s
more, consolidation loans have costs. In addition to interest, you may
have to pay "points," with one point equal to one percent of the amount
you borrow. Still, these loans may provide certain tax advantages that
are not available with other kinds of credit.

Learn about the advantages and disadvantages of debt consolidation for dealing with debts.

In
these challenging economic times, debt consolidation and bankruptcy are
popular debt management strategies. Is debt consolidation or bankruptcy
right for you? To find out, learn about the advantages and
disadvantages of each approach.

Debt Consolidation

Proponents
of debt consolidation often promote this strategy as a simple way to
save money and protect your credit rating. When you consolidate your
debts, you reorganize multiple debt payments into one payment. You can
choose to consolidate debt through a secured loan or an unsecured loan.
(To learn more about the types of debt consolidation, visit Nolo’s Debt Consolidation topic area.)

Pros of Debt Consolidation

Here are some of the advantages of using debt consolidation to better manage your debt.

Protect your reputation and credit rating. Unlike
bankruptcy, debt consolidation is not a matter of public record. Anyone
who looks hard enough will find out about your bankruptcy. Bankruptcy
records are viewable through an electronic subscription service called
PACER or at any federal bankruptcy courthouse. Although a debt
consolidation loan may show up on your credit report, it does not
typically lower a credit score like a bankruptcy filing does.

Maintain your access to credit. Unless
prohibited by the debt consolidation agreement, you can keep your
credit cards. This may be helpful should an emergency arise. However, if
you already owe a significant amount of money or are in default, you
may not be able to use your credit cards or be approved for additional
credit. Also, continued credit card use may defeat the purpose of debt
consolidation.

Simplify your debt management.
When you consolidate your debt, you no longer have to keep up with
multiple payments, at different interest rates, to various creditors.
Instead, you make one convenient payment.

Lower interest rate and monthly payment.
If you consolidate your debts, you may be able to obtain a more
manageable monthly payment, with a lower interest rate. As a result, you
will have more cash available each month to meet your high priority
needs.

Cons of Debt Consolidation

Although
there are some advantages to debt consolidation, it’s not an option to
take lightly. You could end up costing you money in hidden fees and tax
liability. And more important – you could lose property.

You could lose your property. If
you use property such as your home or vehicle as collateral for the
debt consolidation loan, you could lose that property if you default on
the loan payments.

Also,
if a lender gives you a debt consolidation loan, there may be a
cross-collateralization clause that allows that lender to take other
property it has financed if you default on the debt consolidation loan.
For example, let’s say that you have a car loan through your credit
union and then the credit union gives you a debt consolidation loan.
Under the cross-collateralization clause, if you default on the debt
consolidation loan, the credit union could repossess your car – even if
the car payments are current. (Learn more about cross-collateralization.)

Beware of hidden costs. Although
lower interest rates and monthly payments are appealing, a debt
consolidation loan could end up costing you more money. Often, debt
consolidation loans help you achieve a lower monthly payment and
interest rate in exchange for extending the repayment period. If you
stay in debt longer, you may end up paying more over the long term.

Negative tax consequences. Depending
on your financial condition, any money you save from debt relief
services such as debt consolidation may be considered income by the IRS,
which means you pay taxes on it. Credit card companies and other
creditors may report settled debt to the IRS, which the IRS considers
income.